Proposal for a European Parliament and Council Directive amending Council Directive 93/6/EEC on the capital adequacy of investment firms and credit institutions
Date: 1997-04-16
Institutions: European Commission
Subjects: credit guarantee, credit institution, financial solvency, management audit, share capital

COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels,  16.04.1997 
COM(97) 71  final 

97/0124 (COD) 

Proposal for a 
EUROPEAN PARLIAMENT AND COUNCIL DIRECTIVE 

amending Council Directive 93/6/EEC on the capital adequacy 
of investment firms and credit institutions 

(presented by the Commission) 

EXPLANATORY  MEMORANDUM 

The purpose of this proposal is to amend Council Directive 93/6/EEC on capital adequacy 
of  investment  firms  and  credit  institutions  with  respect  to  the  use  of  internal 
risk-management models for the calculation of market risks and the inclusion of measures 
to have appropriate capital available to cover the market risks inherent in commodities and 
commodity derivatives business. 

First,  this is done in response to  the requirement  in Article  14 of Directive  93/6/EEC  to 
developments in 
"examine and if necessary  revise Directive 93/6/EEC in the light  of 
international  fora  of  regulatory  authorities".  This  provision  was  intended  to  ensure  that 
further  work  on  market  risk  being  undertaken  at  that  time  in  the  Basle  Committee  on 
Banking  Supervision would be taken into account in the EU legislation.  The work  of the 
Basle  Committee  culminated  in  the  January  1996  "Amendment  to  the  Basle  Capital 
Accord  to  incorporate  Market  Risks".  This  introduces  into  the  1988  Capital  Accord 
(which  sets  international  standards  for  capital  adequacy  of  international  banks)  a 
standardized  method  for  the measurement  of market risk which  is substantially  the  same 
as that already adopted in Council Directive 93/6/EEC. However,  it also includes the two 
new  elements,  the  use  of  internal  models  and  the  inclusion  of  commodities  in  the 
measurement  of market risks, which are the subjects of this proposal.  The Basle proposal 
will enter into force on 1  January  1998. 

Secondly,  Article  13 of Council Directive 93/6/EEC requires that  "the  Commission  shall 
as soon as possible submit to the Council proposals for  capital requirements in respect  of 
commodities  trading,  commodities  derivatives  ....".  This  task  is  overdue  but  had  been 
delayed  in order to take account  of developments in international  fora  and to  discuss the 
subject  extensively with those mainly concerned.  This proposal draws on the work of the 
Basle  Committee  in this regard  and  the  European  competent  authorities  responsible  for 
the supervision of credit institutions and investment firms have been widely consulted 

The need for the amendments is twofold. 

First,  the  amendment  to  allow  competent  authorities  to  permit  institutions  to  use  their 
internal  models  to  calculate  market  risk  capital  requirements  under  strict  conditions  is 
necessary to  bring EC legislation  up to  date with  modern  practices.  This will  encourage 
institutions to make use of more sophisticated techniques for measuring risk in the context 
of an improved  overall  approach to  risk management.  Such  sophisticated  internal  models 
are capable of measuring  more accurately  the risks involved  in trading  book  activities  of 
banks and investment firms and will enable them to adapt more rapidly to changes in their 
portfolios.  They may therefore reduce the capital charge of an institution compared to the 
standard  approach  of  the  present  Directive  93/6/EEC.  Economically  and  prudentially 
these advanced techniques are highly desirable since they enhance the ability to respond in 
a  timely  and  correct  fashion  to  the  risks  involved  and  to  apportion  the  corresponding 
capital coverage  according to  the necessary  minimum. Not  only will they lead  to  a more 
efficient  use of capital by credit  institutions  and investment firms generally  but  they will 
reduce the need for those institutions to duplicate market risk calculations for internal and 
regulatory  purposes  and  thus  lead  to  significant  cost  savings.  The  Banking  Advisory 
Committee has recommended  that  the amending Directive  should  come into  force  at  the 
same time  as the  Basle  amendment  at  the  end  of  1997 to  avoid  a potential  competitive 
disadvantage  to  EU  institutions  when  non-EU  members  of  the  Basle  Supervisory 
Committee start to allow their institutions to use internal models. 

intended 

this  proposed  Directive  are  not 

Secondly,  commodity  and  commmodity  derivatives  trading  undertaken  by  investment 
firms  and  credit  institutions  are  currently  subject  to  the  &li  credit  risk  charge  under 
Council Directive 89/647/EEC which is not appropriate to the predominantly  market risks 
involved.  It  is  necessary,  therefore,  to  introduce  capital  requirements  which  more 
accurately reflect  these risks. Commodities  and commodity derivatives  are  considered  to 
be  highly  volatile  activities  involving  considerable  risks.  Therefore,  to  the  extent  that 
investment firms and credit institutions undertake these activities incidentally to their other 
authorized activities it is necessary to provide for an adequate capital coverage in order to 
protect depositors and investors of these institutions. The capital requirements  established 
by 
to  provide  rules  for  genuine 
commodities dealers  and  traders  who  should  generally  not  be  covered  by  this 
Directive because  their activities  are  not  included  in  either  of  the  lists  of  activities 
covered by Council Directive  93/22/EEC  (the  Investments  Services  Directive)  or 
Council Directive 89/646/EEC 
Council 
Directive 93/22/EEC  specifically  exempts  institutions  whose  main business  is  trading  in 
commodities  amongst  themselves  or  with  producers  or  professional  users  of  such 
products. With regard  to  the  credit risks of over-the-counter derivatives in  commodities 
the  Commission  has  already  made  a  proposal  to  adapt  the  Solvency  Ratio  Directive 
(89/647/EEC) which, at present, is still under negotiation before the European Parliament 
and the Council.  On the important  issue of the market  risks inherent  in trading  positions 
on commodities and derivatives in commodities this proposal will introduce for investment 
firms  and credit institutions capital requirements considered to be appropriate by the large 
majority  of the  corresponding  supervisory  authorities  of  the  Member  States  and  in  the 
Basle  Committee.  It  must  be  underlined  that  these  requirements  should  apply  solely  to 
institutions  which  deal  mainly  with  the  deposits  or  investments  of  their  clients  and 
aie therefore  subject  to  special  supervisory  rules;  these  rules  should  not  impinge  on 
specialized  professional  traders  who  deal  mainly  for  their  own  account  or  with 
other professionals. 

Banking  Directive) 

(Second 

and 

The  proposed  new  capital  charges  to  cover  the  market  risks  on  commodities  and 
commodity derivatives will, in general, be lower than those required at present  under the 
application  of the  Solvency  Ratio Directive  (which is designed  to  capture  credit  risk) in 
conjunction  with  Council  Directive  93/6/EEC  which  is  to  be  amended.  The  proposed 
Directive provides for three methods: 

-  a simplified  method imposing a very conservative flat capital requirement which should 
ensure  that  regulated  institutions  that  engage  incidentally  in  such risky and  complex 
activities have a comfortable capital cushion, 

-  a  maturity  ladder  approach,  which  -  under  present  circumstances  and  in  the  case  of 
regulated  investment  firms  and  credit  institutions  is  the  most  appropriate  answer  in 
terms  of  the  necessary  capital  coverage  with  regard  to  the  risks  inherent  in  such 
activities. The capital charge will generally be lower than under the first method, 

- 

the internal models which - at present - are not yet sufficiently developed for all aspects 
of  derivatives  activities.  Notably,  appropriate  techniques  have  to  be  developed  for 
options which constitute a large element of commodities derivatives activity. However, 
the proposed Directive is deliberately intended to encourage such developments. 

The proposal  takes  into  account  the  fact  that  in  some Member  States  investment firms 
dealing  primarily  in commodities  and  commodity  derivatives  may not  yet be  able to  use 
internal  models  and  that  the  increase  in  capital  requirements  resulting  from  the  other 
calculation  methods  is  rather  considerable  and  abrupt.  In  order  to  give  those  firms 
sufficient  time to  adapt  or upgrade their risk-management systems in order to be able to 
use internal models, a transitional period may be afforded  to them by their Member  State 
to use alternative rates subject to  some additional prudential and transparency conditions. 
At the same time, it is expected that there will be progress in the further  development  of 
these internal  models  so that  they become  more cost  effective  for  such firms and  at  the 
same time acceptable to the competent  authorities, notably with regard  to the capture of 
the non-linear risks related to the options trade in commodities. 

ARTICLE I 

Point  1(a)  brings  commodities  and  commodity  derivatives  into  the  definition  of  the 
trading book  which constitutes the element  of an institution's  activities on which  market 
risk capital charges are levied. 

Point 1(b)  broadens  the  definition  of  "warrant"  so  that  the  term  may  also  relate  to 
commodities.  In  some  markets  a  commodity  warrant  is understood  to  be  an  ownership 
instrument rather than a right to purchase. For the purposes of this Directive the meaning 
of a warrant in the context of commodities will be as defined  in this text. The definition  of 
"covered  warrant" is deleted because the definition  of warrant  includes covered  warrants 
and  the  capital  adequacy  treatment  is  identical.  Stock financing is  defined  in  order  to 
clarify  the exemption of stock financing from the capital requirements for  commodities in 
Annex VII(3). 

Point  1(c) and (d) ensures that commodities are treated  consistently with securities with 
regard to capital requirements for repos/reverse repos and borrowing/lending transactions. 

Point  2 incorporates  the  option to  use  models  for  the  calculation  of  capital  charges  for 
market risk in the trading book, while point (ii) includes commodities in the calculation of 
capital charges for market risk on all business activities and incorporates the option to use 
models. 

Point 3 ensures that all institutions, including those which use internal models to calculate 
capital  requirements  for  trading  book  business,  are  subject  to  the  large  exposures 
requirements  for  exposures  to  individual  clients  which  arise  on  the  trading  book 
irrespective  of  whether  those  large  exposures  are  identified  under  the  internal  models 
approach or the standardized approach. 

Point  4  brings  capital  requirements  calculated  under  the  internal  models  approach  and 
charges  for  commodity  positions  calculated  according  to  Annex  VII  under  the 
consolidation  provisions  of  this  Article.  Commodity  positions  may  be  offset  against 
opposite commodity positions in consolidated  third country undertakings under  the same 
conditions that such foreign-exchange  positions may be offset. 

Point 5 brings commodities into the reporting requirements. 

Points  6  inserts  Article  12a  which  contains  a  transitional  clause  allowing  competent 
authorities  to  exempt  investment  firms  from  the  application  of  Annex  VII  until 
31 December 1999. 

Point 7 refers to the amendments to Annexes I to VI. 

Point 8 adds Annexes VII and VIII. 

t 

ARTICLES 2,3 AND 4 

These  Articles  contain  administrative  arrangements  regarding  the  adoption  of  this 
Directive and its implementation by Member States. 

ANNEX I 
«, 

Point  1(a) brings the  internal  models  approach  into  this  provision  which  allows  capital 
requirements  for  an  exchange-traded  future  to  be  equal  to  the  margin  required  by  the 
exchange if the competent  authority is satisfied  that this provides an accurate measure of 
the  associated  risks  and  that  the  method  used  to  calculate  the  margin  is  equivalent  to 
either  the  standardized  or  internal  models  approach  in  Annex  1 or  Annex  VIII  of  the 
revised Directive. 

Point  1(b) brings the internal models approach into this provision which relates to capital 
requirements for options. 

Point  1(c)  is  consequential  to  the  amendment  to  the  definition  of  "warrant"  and  the 
deletion of the defimtion of "covered warrant". 

Point  1(d) corrects the unintended  effect  of the existing wording which excludes from the 
concessionary  specific  risk  charge  in this provision  highly rated  issuers who  have  issued 
subordinated debt. 

Point  2(a),  (b)  and  (c)  brings  commodities  under  the  settlement/delivery  and 
counterparty risk-capital requirements. 

Point  3(a), (b) and  (c)  brings gold  into the  capital  regime set  out  in Annex  III.  This is 
consistent with the Basle decision to treat gold as a foreign-exchange  position because its 
volatility  is more  in  line  with  foreign  currencies  and  institutions  manage  it  in  a  similar 
manner  to  foreign  currencies.  Point  3(a)  also  introduces  more  stringent  capital 
requirements  by  converting  the  2%  "free  zone"  into  a  2%  "threshold".  A  minor 
adjustment  to the wording regarding irrevocable guarantees is also included in point 3(b). 

Point  3(d)  amends  the  alternative  calculation  of  foreign-exchange  risk  in  Annex  III 
paragraph  7  of  the  Council  Directive  93/6/EEC  requiring  the  necessary  analysis  to  be 
done by competent  authorities on the basis of the standards required for  internal  models 
under Annex 1, paragraph 20, of the Directive. 

Point 4(a), (b) and (c) extends the use of and limits on Tier 3 capital (subordinated  loan 
capital with an initial maturity of at least two years and meeting the requirements  set  out 
in Annex V to Directive  93/6/EEC) for  meeting commodity risks and trading book  risks 
calculated by internal models. 

Point  5(a)  and  (b)  ensures  that  all  institutions,  including  those  that  use  models  to 
calculate  trading  book  positions,  are  subject  to  the  large  exposure  requirements  on 
exposures  to  individual  clients  which  arise  on  the  trading  book  irrespective  of  whether 
those exposures are identified by a model or by the standardized approach. 

ANNEXH 

Commodities  risk 

A  new  Annex  VII  is  added  which  sets  out  methods  for  calculating  market  risk  on 
positions  in  commodities  and  commodity  derivatives.  The  main  risks  the  methods  are 
designed  to  capture  are  the  "directional  risk"  arising  from  a  change  in  the  spot  price, 
"basis  risk"  arising  from  potential  changes  in the  relationship  between  prices  of  similar 
commodities  over time, "interest-rate  risk"  arising from potential  changes  in the  cost  of 
funding  forward  positions and options, and "forward  gap risk" arising from other potential 
changes in the forward  price. 

A maturity ladder  method  sets capital charges  against  matched positions within  maturity 
bands and between maturity bands to capture basis risk, interest-rate risk and forward  gap 
risk  and  on  the  residual  unmatched  position  to  capture  directional  risk.  An  alternative 
simplified  method  sets  a capital  charge  on the overall  net  position  to  capture  directional 
risk  and  on  the  gross  positions  in  each  commodity  to  capture  basis,  interest  rate  and 
forward  gap risks. A third  method  available is the internal  models approach  described  in 
Annex VIII. 

It  is  not  the  purpose  of  this  Directive  to  cover  the  markets  for  commodities  and 
derivatives  in commodities  and  operators  in these  markets  in general.  Commodities  and 
derivatives  on  commodities  are  not  on  the  list  of  activities  to  be  covered  under  the 
Second Banking  Coordination  Directive  or  the  Investment  Services  Directive  (ISD). 
It is also  explicitly  indicated  in  Article  2(2)  of  the  ISD  that  it  "shall  not  apply  to:  ... 
(i) persons  whose  main  business  is  trading  in  commodities  amongst  themselves  or  with 
6 

producers  or  professional  users  of  such  products  and  who  provide  investment  services 
only for  such producers and professional  users to the extent  necessary for their business"; 
therefore  the  major  part  of  business  in  commodities  markets  need  not  be  covered  and 
hence need not be affected  by the proposed changes to the Capital Adequacy Directive. 

This  Directive  should,  however,  apply  to  the  commodities  and  derivative  commodities 
business done by credit institutions and investment firms since they operate on behalf of or 
with the money of their clients. As in other areas prudential  regulation  should  ensure  the 
financial stability  and  protect  the  customers  of  these  institutions.  Commodities  and 
derivatives on commodities business is extremely risky and volatile  so if authorized  credit 
institutions or investment firms want to deal in these activities for their own account  or on 
behalf  of their  clients,  there  is  a need  for  special  protection  in  order  to  limit  a  possible 
negative  impact  from  such  business  on  the  institution's  solvency  and  overall  stability. 
Annex  VII  deals  with  these  problems  in  introducing  internationally  recognised  capital 
requirements  for  credit  institutions  and  investment  firms.  It  follows  closely  the 
approach adopted in the amendment to the Basle Capital Accord  and  its introduction will 
contribute  to  a  level  regulatory  playing  field  both  within  the  EU  and  in  the  wider 
international marketplace. 

Internal models 

A new Annex VIII is added which  sets out  conditions for  the use  of  internal  models  for 
calculating  market  risk  capital  requirements  for  all trading  book  activities.  Thus,  to  the 
extent  that  models  are  sufficiently  developed  to  capture  the  relevant  risks,  they  may  be 
used  for  commodities  and  commodity  derivatives  as well.  The objective  is to  encourage 
the use of more accurate techniques for  measuring risk in the overall context  of improved 
risk management in credit institutions and investment  firms. 

The Annex makes the use of internal models conditional upon the explicit approval  of the 
financial institution's  competent  supervisory  authority  and  sets  strict  quantitative  and 
qualitative standards for such approval. It specifies the minimum market risk factors  which 
must be covered and requires that the "value at risk" produced each day be multiplied by a 
minimum  factor  of  3  to  account  for  potential  weaknesses  in  modelling  techniques.  In 
addition a plus factor  of between 0 and  1 must be added to the "value at risk" based on a 
regular back-testing programme to verify the model's accuracy. 

This  Annex  also  follows  closely  the  approach  adopted  in  the  amendment  to  the  Basle 
Capital Accord and its introduction will contribute to a level regulatory playing field both 
within the EU and in the wider international market place. 

Proposal for a 
EUROPEAN PARLIAMENT AND COUNCIL DIRECTIVE 

amending Council Directive 93/6/EEC on the capital adequacy 

of investment firms and credit institutions 

(Text with EE A relevance) 

THE  EUROPEAN  PARLIAMENT  AND  THE  COUNCIL  OF  THE 
EUROPEAN UNION, 

Having regard to the Treaty establishing the European  Community,  and in particular  the 
first and third sentences of Article 57(2) thereof, 

Having regard to the proposal from the Commission1, 

Having regard to the opinion of the Economic and Social Committee2, 

Having regard to the opinion of the European Monetary Institute3, 

Acting in accordance with the procedure referred  to in Article  189b of the Treaty4, 

institutions5,  as 

Whereas  the  risks  associated  with  commodities  trading  and  commodity  derivatives  are 
currently  subject  to  Council  Directive  89/647/EEC  of  18 December  1989 on  a  solvency 
ratio  for  credit 
the 
European Parliament  and of the Council6; whereas, however,  the market risks associated 
with those  positions are not  captured  accurately  by Directive  89/647/EEC; whereas  it is 
necessary  to  extend  the  concept  of  the  "trading  book"  to  positions  in  commodities  or 
commodity  derivatives  which  are  held  for  trading  purposes  and  are  subject  mainly  to 
market risks;whereas institutions must comply with this Directive as regards the coverage 
of commodity risks on their overall business; 

last  amended  by  Directive  96/10/EC  of 

Whereas  Council  Directive  93/6/EEC  of  15  March  1993  on  the  capital  adequacy  of 
investment  firms  and  credit  institutions7  lays  down  a  standardized  method  for  the 
calculation of capital requirements for market risks incurred by investment firms and credit 
institutions;  whereas  institutions  have  developed  their  own  risk-management  systems 
(internal models), designed to measure more accurately than the standardized  method  the 
market ricks incurred by investment firms and credit institutions; whereas the use of more 
accurate methods of measuring risks should be encouraged; 

1  OJNoC 
2  OJNoC 
3  OJNoC 
4  OJNoC 
5  OJ No L 386, 30.12.1989, p.  14. 
6  OJNoL85, 3.4.1996, p.  17. 
7  OJNoL 141, 11.6.1993, p. 1. 

Whereas  the  use  of  such  internal  models  for  the  purpose  of  calculating  capital 
requirements  requires  strict  internal  control  mechanisms  and  should  be  subject  to 
authorization  and  supervision  by  the  competent  authorities;  whereas  the  continued 
reliability  of  the  results  of  the  internal  model  calculation  should  be  verified  by  a 
back-testing procedure; 

Whereas  the  rules  adopted  at  the  wider  international  level  may,  in  order  to  encourage 
more  sophisticated  risk-management  methods  based  on  internal  models,  lower  capital 
requirements for  credit institutions from third  countries; whereas those  credit  institutions 
compete with investment firms and credit  institutions incorporated  in the Member  States; 
whereas  for  investment firms and  credit  institutions  incorporated  in the Member  States, 
only  an  amendment  of  Directive  93/6/EEC  can  provide  similar  incentives  for  the 
development and use of internal models; 

Whereas for the purpose of calculating market-risk-capital  requirements, positions in gold 
and gold derivatives should be treated in a similar fashion to foreign-exchange  positions; 

Whereas  the  issue  of  sub-ordinated  debt  should  not  automatically  exclude  an  issuer's 
equity  from  being  included  in  a  portfolio  qualifying  for  a  2%  specific-risk  weighting 
according to point 33 of Annex I to Directive 93/6/EEC; 

Whereas this Directive is in accordance with  the work  of  another  international  forum  of 
banking  supervisors  on  the  supervisory  treatment  of  market  risk  and  of  trading-book 
positions in commodities and commodity derivatives; 

Whereas  some  investment  firms  dealing  primarily  in  commodities  and  commodity 
derivatives  may  not  yet  be  able  to  use  internal  models  or  to  comply  with  the  capital 
requirements  for  commodities risk as laid  down in this Directive; whereas  it  is expected 
internal  models  for  investment  firms  on  the  risk 
that  appropriate,  cost-effective 
management  of commodities  and  commodities  derivatives,  in particular  for  options,  will 
be available shortly; whereas, in order to give those firms sufficient  time to upgrade their 
risk-management  systems, competent  authorities, under  certain  conditions,  should  not be 
obliged  to  prescribe  the  capital  charges  for  commodities  referred  to  in  Annex  VII  to 
Directive 93/6/EEC for investment firms before  1  January 2000; 

Whereas adoption of this Directive constitutes the most appropriate means of attaining the 
desired  objectives;  whereas this Directive  is  limited  to  the  minimum  necessary to  attain 
these objectives and does not go beyond what is needed for this purpose; 

Whereas  this  Directive  concerns  the  European  Economic  Area  (EEA)  and  whereas  the 
procedure  under  Article  99  of  the  Treaty  on  the  European  Economic  Area  has  been 
complied with; 

Whereas  the  Banking  Advisory  Committee  has  been  consulted  on  the  adoption  of 
this Directive; 

HAVE ADOPTED THIS DIRECTIVE: 

Article 1 

Directive 93/6/EEC is amended as follows: 

1. 

Article 2 is amended as follows: 

(a)  Point  6(a)  and  (b),  the  introductory  phrase  and  (i)  and  (ii)  are  replaced  by 

the following: 

"(a) 

(b) 

its  proprietary  positions  in  financial  instruments,  commodities  and 
commodity  derivatives,  which  are  held  for  resale  and/or  which  are 
taken on by the  institution with the intention  of benefiting  in the  short 
term from actual and/or expected differences  between their buying and 
selling  prices,  or  from  other  price  or  interest-rate  variations,  and 
positions 
in  financial  instruments,  commodities  and  commodity 
derivatives,  arising from matched principal  broking,  or positions  taken 
in order to hedge other elements of the trading book; 

the  exposures  due  to  the  unsettled  transactions,  free  deliveries 
and over-the-counter  (OTC)  derivative  instruments  referred  to  in 
paragraphs  1, 2,  3 and 5 of Annex II, the exposures due to  repurchase 
agreements  and  securities  and  commodities  lending  which  are  based 
on securities or commodities included in the trading book  as defined in 
(a) referred  to  in  paragraph  4  of  Annex  II,  those  exposures  due  to 
reverse 
and 
commodities-borrowing  transactions  described  in the  same paragraph, 
provided  the  competent  authorities  so  approve,  which  meet  either the 
conditions (i), (ii), (iii) and (v) or conditions (iv) and (v) as follows: 

repurchase  agreements  and 

securities-borrowing 

(i) 

(ii) 

the  exposures  are  marked  to  market  daily  following  the 
procedures laid down in Annex II; 

the  collateral  is  adjusted  in  order  to  take  account  of  material 
changes in the value of the  securities or commodities involved  in 
the  agreement  or  transaction  in  question,  according  to  a  rule 
acceptable to the competent authorities;" 

(b)  Points  15 and  16 are replaced by the following: 

"15.  warrant  shall  mean  a  security  which  gives  the  holder  the  right  to 
purchase  an underlying  at  a  stipulated  price  until  or  at  the  warrant's 
expiry date. It may be settled by the delivery  of the underlying itself or 
by cash settlement. 

16. 

stock  financing  shall  mean  positions,  where  physical  stock  has  been 
sold forward  and the  cost  of funding  has been locked  in until the  date 
of the forward  sale." 

10 

(c)  Point  17, first sentence, is replaced by the following: 

"17.  repurchase agreement and  reverse repurchase agreement  shall  mean 
any  agreement  in  which  an  institution  or  its  counter-party  transfers 
securities  or  commodities  or  guaranteed  rights  relating  to  title  to 
securities  or  commodities  where  that  guarantee  is  issued  by  a 
recognised  exchange  which  holds  the  rights  to  the  securities  or 
commodities  and  the  agreement  does  not  allow  an  institution  to 
transfer or pledge a particular security or commodity to more than one 
counter-party at one time, subject to a commitment to repurchase them 
(or substituted  securities or commodities of the same description) at a 
specified  price  on  a  future  date  specified,  or  to  be  specified,  by  the 
transferor,  being a repurchase agreement for the institution  selling the 
securities or commodities and a reverse repurchase agreement for  the 
institution buying them." 

(d)  Point  18 is replaced by the following: 

"18.  securities  or  commodities  lending  and  securities  or  commodities 
borrowing shall  mean  any  transaction  in  which  an  institution  or  its 
counter-party  transfers  securities  or  commodities  against  appropriate 
collateral  subject  to  a  commitment  that  the  borrower  will  return 
equivalent  securities  or  commodities  at  some  future  date  or  when 
requested  to  do  so by the transferor,  that  transaction  being  securities 
or commodities lending for the institution transferring  the securities or 
commodities  and  being  securities  or  commodities  borrowing  for  the 
institution to which they are transferred. 

Securities  or  commodities  borrowing  shall  be  considered  an 
interprofessional  transaction  when  the  counterparty  is  subject  to 
prudential  coordination  at  Community  level  or  is  a  Zone  A  credit 
institution  as  defined  in  Directive  89/647/EEC  or  is  a  recognised 
third-country  investment  firm  or  when  the  transaction  is  concluded 
with a recognized clearing house or exchange;" 

2. 

Article 4(1), first subparagraph, points (i) and (ii), are replaced by the following: 

"(i) 

the capital requirements, calculated in accordance with Annexes I, II and VI 
and as appropriate Annex VIII, for their trading-book business; 

(ii) 

the capital requitements, calculated  in accordance with Annexes HI and  VII 
and as appropriate Annex VIII, for all of their business activities;" 

3. 

Article 5(2) is replaced by the following: 

"2.  Notwithstanding  paragraph  1, those  institutions  which  calculate  the  capital 
requirements  for  their  trading-book  business  in  accordance  with  Annexes I 
ma  II, and as appropriate Annex VIII, shall monitor and control  their  large 
to  the 
exposures  in  accordance  with  Directive  92/121/EEC  subject 
modifications laid down in Annex VI to this Directive." 

11 

4. 

Article 7(10) and (11), first sentence,  are replaced by the following: 

"10.  Where  the  rights  of  waiver  provided  for  in  paragraphs  7  and  9  are  not 
exercised,  the  competent  authorities  may,  for the  purpose  of  calculating  the 
capital  requirements  set  out  in  Annexes  I  and  VIII  and  the  exposures  to 
clients  set  out  in Annex  VI  on  a  consolidated  basis,  permit  net  positions  in 
the trading book  of one institution to  offset  positions  in the trading book  of 
another institution according to the rules set out in Annexes I, VI and VIII. 

In addition,  they  may  allow  foreign-exchange  positions  in one  institution  to 
offset  foreign-exchange  positions  in  another  institution  in  accordance  with 
the  rules  set  out  in  Annex  III  and/or  Annex  VIII.  They  may  also  allow 
commodities  positions  in  one  institution  to  offset  commodities  positions  in 
another institution in accordance with the rules set  out  in Annex  VII  and/or 
Annex VIII. 

11.  The competent  authorities may also permit offsetting  of the trading book and 
of  the  foreign-exchange  and  commodities  positions,  respectively,  of 
undertakings located in third countries, subject to the simultaneous  fulfilment 
of the following  conditions:" 

5. 

Article 8(5) is replaced by the following: 

"5.  The  competent  authorities  shall  oblige  institutions  to  report  to  them 
immediately any case in which their counterparties in repurchase and reverse 
repurchase  agreements  or  securities  and commodities-lending  and  securities 
and  commodities-borrowing  transactions  default  on  their  obligations.  The 
Commission  shall report  to  the  Council  on  such cases  and their  implications 
for  the  treatment  of  such  agreements  and  transactions  in this  Directive  not 
more  than three  years  after  the  date  referred  to  in  Article  12.  Such  reports 
shall also describe the way that institutions meet those of conditions (i) to (v) 
in Article 2(6)(b) that apply to them, in particular condition (v).  Furthermore 
it  shall  give  details  of  any  changes  in  the  relative  volume  of  institutions' 
traditional  lending  and their  lending  through  reverse  repurchase  agreements 
and  securities-borrowing  or  commodities-borrowing  transactions.  If  the 
Commission  concludes  on  the  basis  of  this  report  and  other  information 
that further  safeguards  are  needed  to  prevent  abuse, 
it  shall  make 
appropriate proposals." 

6. 

Article  12a is inserted: 

"Article  12a 

1.  Member  States  whose  investment  firms,  in  the  opinion  of  their  competent 
authorities, are not yet in a position to use internal models for the purpose  of 
calculating  the  capital  requirement  on  commodities  risk  in  accordance  with 
Annex VIII may, until 31 December  1999, prescribe alternative  spread, carry 
and outright rates from those indicated in Annex VII, paragraphs  13 and  16. 

12 

2. 

The  alternative  rates  described 
following  conditions: 

in  paragraph  1  are  subject  to  the 

(i) 

the alternative rates are set by the competent  authorities; 

(ii) 

the  competent  authorities  review  the  alternative  rates  regularly  in  the 
light of developments in commodities markets; 

(iii) 

the alternative rates are in no case lower than half the rates  prescribed 
in paragraphs  13 and  16 of Annex VII; 

(iv) 

the  competent  authorities  notify  the  Commission  of  the  alternative 
rates  and  make  available 
to  other 
Member States the data on the basis of which the alternative rates have 
been calculated." 

the  Commission  and 

to 

7. 

Annexes  I,  II,  III,  V  and  VI  are  amended  in  accordance  with  Annex  I  to 
this Directive. 

8. 

Annexes VII and VIII set out in Annex II to this Directive are added. 

Article 2 

1. 

Member  States  shall  bring  into  force  the  laws,  regulations  and  administrative 
provisions  necessary  to  comply  with  this  Directive  by  31  December  1997  at  the 
latest. They shall immediately inform the Commission  thereof. 

When Member States adopt these provisions, these shall contain a reference to this 
Directive  or  shall  be  accompanied  by  such  reference  at  the  time  of  their  official 
publication.  The procedure for such reference shall be adopted by Member States. 

2. 

Member  States  shall  communicate  to  the  Commission  the  text  of  the  main 
provisions of national law which they adopt in the field covered by this Directive. 

Article 3 

This Directive  shall  enter into  force  on the twentieth  day following  that  of its  publication 
in the Official Journal  of the European  Communities. 

This Directive is addressed to the Member States. 

Article 4 

Done at Brussels, 

For the European Parliament 
The President 

For the Council 
The President 

13 

ANNEX  I 

1. 

Annex  I is amended as follows: 

(a) 

In paragraph 4, the last sentence is replaced by the following: 

"The  competent  authorities  may  allow  the  capital  requirement  for  an 
exchange-traded future to be equal to the margin required by the exchange  if 
they  are  fully  satisfied  that  it  provides  an  accurate  measure  of  the  risk 
associated  with the future  and that the method used  to  calculate  the  margin 
is  equivalent  to  the  method  of  calculation  set  out  in  the  remainder  of  this 
Annex or in Annex VIII." 

(b) 

In paragraph 5, the third subparagraph is replaced by the following: 

"The competent  authorities  shall require that  the  other risks, apart from the 
delta  risk,  associated  with  options  are  safeguarded  against.  The  competent 
authorities  may  allow  the  requirement  against  a  written  exchange-traded 
option  to  be  equal  to  the  margin  required  by the  exchange  if they  are  fully 
satisfied  that  it provides  an accurate  measure  of the risk associated  with the 
option  and that the method  used  to  calculate  the margin is  equivalent  to  the 
method  of  calculation  set  out  in  the  remainder  of  this  Annex  or  in 
Annex VIII for  such options.  In addition they may allow the  requirement  on 
a  bought  exchange-traded  or  OTC  option  to  be  the  same  as  that  for  the 
instrument  underlying  it,  subject  to  the  constraint  that  the  resulting 
requirement  does  not  exceed  the  market  value  of  the  option.  The 
requirement  against  a  written  OTC  option  shall  be  set  in  relation  to  the 
instrument underlying it." 

(c)  Paragraph 6 is replaced by the following: 

"6.  Warrants  relating  to  debt  instruments  and  equities  shall  be  treated  in 

the same way as options under paragraph 5." 

(d)  Paragraph 33(i) is replaced by the following: 

"(i) 

the equities shall not be those  of issuers which have issued  only traded 
debt  instruments  that  currently  attract  an  8%  requirement  in  Table  1 
appearing  in  paragraph  14  or  that  attract  a  lower  requirement  only 
because they are guaranteed or secured;" 

14 

2. 

Annex II is amended as follows: 

(a)  Paragraph  1  is replaced by the following: 

"1. 

In  the  case  of  transactions  in  which  debt  instruments,  equities  and 
commodities (excluding repurchase and reverse repurchase agreements 
and  securities  or  commodities  lending  and  securities  or  commodities 
borrowing)  are  unsettled  after  their  due  delivery  dates,  an  institution 
must  calculate  the  price  difference  to  which  it  is exposed.  This is the 
difference  between the agreed  settlement price for the debt  instrument, 
equity  or  commodity  in question  and  its current  market  value,  where 
the difference  could involve a loss for  the institution.  It  must  multiply 
this  difference  by  the  appropriate  factor  in  column  A  of  the  table 
appearing in paragraph 2 in order to calculate its capital requirement." 

(b)  Paragraph 3 is replaced by the following: 

"3.1.  An  institution  shall  be  required  to  hold  capital  against  counterparty 

risk if: 

(i) 

it has paid for securities or commodities before receiving them or 
it  has  delivered  securities  or  commodities  before  receiving 
payment for them; and 

(ii) 

in  the  case  of  cross-border  transactions,  one  day  or  more  has 
elapsed since it made that payment or delivery. 

3.2.  The capital  requirement  shall  be  8%  of the value  of  the  securities  or 
commodities  or  cash  owed  to  the  institution  multiplied  by  the  risk 
weighting applicable to the relevant  counterparty." 

(c)  The heading to paragraph 4 and the first subparagraph  of paragraph  4.1  are 

replaced by the following: 

"Repurchase  and  reverse  repurchase  agreements,  securities  or 
commodities lending and borrowing 

4.1.  In  the  case  of  repurchase  agreements  and  securities  or  commodities 
lending  based  on  securities  or  commodities  included  in  the  trading 
book  the institution  shall calculate the  difference  between  the  market 
value  of  the  securities  or  commodities  and  the  amount  borrowed  by 
the  institution  or  the  market  value  of  the  collateral,  where  that 
difference  is positive. In the case of reverse repurchase agreements and 
securities or commodities borrowing, the institution shall calculate the 
difference  between  the  amount  the  institution  has  lent  or  the  market 
value  of  the  collateral  and  the  market  value  of  the  securities  or 
commodities it has received, where that difference  is positive." 

15 

Annex III is amended as follows: 

(a)  Paragraph 1  is replaced by the following: 

"1. 

If the sum of an institution's overall net foreign-exchange  position and 
its  net  gold  position,  calculated  in  accordance  with  the  procedure 
set out  below,  exceeds  2% of  its  total  own  funds,  it  shall  multiply 
the sum of its net foreign-exchange  position and its net gold position 
by  8%  in  order  to  calculate  its  own-funds  requirement  against 
foreign-exchange  risk." 

(b)  Paragraph 3 is replaced by the following: 

"3.1.  Firstly,  the 

institution's  net  open  position 

in  each  currency 
(including the  reporting  currency)  and  in  gold  shall  be  calculated. 
This position  shall  consist  of  the  sum  of  the  following  elements 
(positive or negative): 

the  net  spot  position  (i.e.  all  asset  items less  all  liability items, 
including  accrued  interest,  in  the  currency  in  question  or,  for 
gold, the net spot position in gold), 

the net forward position (i.e.  all amounts to be received less all 
amounts  to  be  paid  under  forward  exchange  and  gold 
transactions,  including  currency  and  gold  futures  and  the 
principal on currency swaps not included in the spot position), 

irrevocable guarantees (and similar instruments) that are certain 
to be called and likely to be irrecoverable, 

net  future  income/expenses  not  yet  accrued  but  already  fully 
hedged (at the discretion of the reporting institution and with the 
prior  consent  of  the  competent  authorities,  net 
future 
income/expenses  not  yet  entered  in  accounting  records  but 
already  fully  hedged  by  forward  foreign-exchange  transactions 
may be included here).  Such discretion must be exercised  on a 
consistent basis, 

the  net  delta  (or  delta-based)  equivalent  of  the  total  book  of 
foreign-currency and gold options* 

the  market  value  of  other  (i.e.  non-foreign-currency  and 
non-gold) options, 

16 

any positions which an institution has deliberately taken in order 
to  hedge  against the adverse effect  of the  exchange  rate  on its 
capital ratio may be  excluded from the  calculation  of  net  open 
currency positions.  Such positions should be of a non-trading or 
structural  nature  and  their  exclusion,  and  any  variation  of  the 
terms  of  their  exclusion,  shall  require  the  consent  of  the 
competent  authorities.  The same treatment  subject  to  the same 
conditions  as  above  may  be  applied  to  positions  which  an 
institution has which relate to items that are already deducted in 
the calculation of own funds. 

3.2.  The  competent  authorities  shall  have  the  discretion  to  allow 
institutions to use the net present value when calculating the net open 
position in each currency and in gold." 

(c)  Paragraph 4, first sentence, is replaced by the following: 

"4.  Secondly, net short and long positions in each currency other than the 
reporting currency and the net long or short position in gold  shall be 
converted at spot rates into the reporting currency." 

(d)  Paragraph 7 is replaced by the following: 

"7.  Secondly, the competent authorities may allow institutions to apply an 
alternative  method  to  those  outlined  in  paragraphs  1  to  6  for  the 
purposes  of  this  Annex.  The  capital  requirement  produced  by  this 
method must be  sufficient  to  exceed  2% of  the  net  open  position  as 
measured in paragraph 4 and, on the basis of an analysis of exchange-
rate movements during all the rolling  10-working-day periods over the 
preceding  three  years,  to  exceed  the  likely  loss  99%  or  more  of 
the time. 

The alternative method described in this paragraph may only be used 
under the following conditions. 

(i) 

(ii) 

the  calculation  formula  and  the  correlation  coefficients  are 
set by the  competent  authorities,  based  on  their  analysis  of 
exchange-rate movements; 

competent 

the 
coefficients regularly 
foreign-exchange markets." 

authorities 
the 

in 

review 

the 

light  of  developments 

correlation 
in 

Annex V is amended as follows: 

(a)  Paragraph 2, first sentence, is replaced by the following: 

"Notwithstanding  paragraph  1, the competent  authorities may permit those 
institutions which are obliged to meet the own-funds requirements laid down 
in Annexes I,  II,  III,  IV,  VI,  VII  and VIII  to use  an alternative  definition 
when meeting those requirements only." 

17 

(b)  Paragraph 4 is replaced bythe  following: 

"4.  The  subordinated  loan  capital  referred  to  in  paragraph  2(c)  may  not 
exceed  a maximum of  150% of the original  own funds left  to  meet the 
requirements laid down in Annexes I, II, III, IV,  VI,  VII,  and VIII and 
may  approach  that  maximum  only 
in  particular  circumstances 
acceptable to the relevant authorities." 

(c)  Paragraphs 6 and 7 are replaced by the following: 

"6.  The  competent  authorities  may permit  investment firms to  exceed  the 
ceiling  for  subordinated  loan  capital  prescribed  in paragraph  4  if they 
judge  it  prudentially  adequate  and  provided  that  the  total  of  such 
subordinated  loan capital  and the items referred to in paragraph  5 does 
not  exceed  200%  of  the  original  own  funds  left  to  meet  the 
requirements  imposed  in  Annexes  I,  II,  III,  IV,  VI,  VII  and  VIII  or 
250%  of  the  same  amount  where  investment  firms  deduct  item  2(d) 
referred to in paragraph 2 when calculating own funds. 

7. 

The competent  authorities may permit the ceiling for  subordinated  loan 
capital prescribed in paragraph 4 to be  exceeded by a credit  institution 
if  they judge  it  prudentially  adequate  and  provided  that  the  total  of 
such subordinated  loan capital and the items referred to in paragraph 5 
does  not  exceed  250%  of  the  original  own  funds  left  to  meet  the 
requirements imposed in Annexes I, II, III, VI, VII and VIII." 

5. 

Annex VI is amended as follows: 

(a)  Paragraph 2(i) is replaced by the following: 

"(i) 

the  excess  - where  positive  -  of  an institution's  long  positions  over  its 
short  positions  in  all  the  financial  instruments  issued  by  the  client 
in question;" 

(b)  Paragraph 8(2),  second subparagraph, is replaced by the following: 

"As  from  10  days  after  the  excess  has  occurred,  the  components  of  the 
excess,  selected  in  accordance  with  the  above  criteria,  shall  be  allocated  to 
the  appropriate  line  in  column  1  of  the  table  below  in  ascending  or^er  of 
specific-risk  requirements  in  Annex  I  and/or,  if  applicable,  Annex  VIII 

for requirements in Annex II. 

The institution  shall then meet  an additional  capital requirement  equal to  the 
sum  of the  specific-risk  requirements  in Annex  I,  Annex  VIII,  if  applicable, 
and/or  the  Annex  II  requirements  on  these  components  multiplied  by  the 
corresponding factor in column 2;" 

18 

ANNEX II 

"ANNEXVII 

COMMODITIES RISK 

1. 

2. 

3. 

4. 

5. 

6. 

7. 

8. 

Each  position  in  commodities  or  commodity  derivatives  shall  be  expressed  in 
terms of the standard unit of measurement. The spot price in each commodity shall 
be expressed in the reporting currency. 

Positions  in  gold  or  gold  derivatives  shall  be  considered  as  being  subject  to 
foreign-exchange  risk  and  treated  according  to  Annex  in  or  Annex  VIII,  as 
appropriate, for the purpose of calculating market risk. 

For the purposes of this Annex, positions which are purely stock financing may be 
excluded from the commodities risk calculation only. 

The  interest-rate  and  foreign-exchange  risks  not  covered  by  other  provisions  of 
this  Annex  shall be  included  in the  calculation  of  General  Risk  for  Traded  Debt 
Instruments and in the calculation of Foreign-Exchange Risk. 

When the  short  position  falls  due before  the  long  position,  institutions  shall  also 
guard against the risk of a shortage of liquidity which may exist in some markets. 

Netting 

For  the  purpose  of  paragraph  17,  the  excess  of  an  institution's  long  (short) 
positions  over  its  short  (long)  positions  in  the  same  commodity  and  identical 
commodity  futures,  options  and  warrants  shall  be  its  net  position  in  each 
* commodity.  The  competent  authorities  shall  allow  positions  in  derivative 
instruments to be treated,  as laid down in paragraphs  8, 9 and  10, as positions in 
the underlying commodity. 

The competent authority may permit offsetting  between different  sub-categories of 
commodities in cases where the  sub-categories  are deliverable  against  each  other 
or  between  similar  commodities  if  they  are  close  substitutes  and  a  minimum 
correlation  between  them  of  90%  over  a  minimum  of  one  year  can  be  clearly 
established.  No  offsetting  may  be  permitted,  however,  where  the  two  legs  of  a 
commodity  swap  are  in different  commodities  which  do  not  belong  to  the  same 
sub-category as defined above. 

Particular instruments 

Commodity  futures  and  forward  commitments  to  buy  or  sell  individual 
commodities shall be incorporated  in the measurement system as notional amounts 
in  terms  of  the  standard  unit  of  measurement  and  assigned  a  maturity  with 
reference  to  expiry  date.  The  competent  authorities  may  allow  the  capital 
requirement  for  an exchange-traded  future  to  be equal  to the margin required  by 
the exchange if they are fully  satisfied  that it provides an accurate measure of the 

19 

9. 

10. 

risk associated  with the future  and that the method used to  calculate the margin is 
equivalent to the method of calculation set out in this Annex or in Annex VIII. 

Commodity  swaps where  one  side of the transaction is a fixed price  and the  other 
the current market price shall be incorporated into the maturity ladder approach as 
a  series  of  positions  equal  to  the  notional  amount  of  the  contract,  with  one 
position  corresponding  with  each  payment  on  the  swap  and  slotted  into  the 
maturity ladder (Table 4) accordingly.  The positions would be long positions if the 
institution is paying a fixed price and receiving  a floating price and short  positions 
if the institution is receiving a fixed price and paying a floating price. 

Commodity  swaps where  the  sides of the transaction  are in different  commodities 
are  to  be  reported 
the  maturity 
ladder approach. 

in  the  relevant  reporting 

ladder  for 

Options  on commodities  or commodity  derivatives  shall be treated as if they  were 
positions equal in value to the amount of the underlying to which the option refers, 
multiplied by its delta for the purposes  of this Annex.  The latter positions may be 
netted off against any offsetting  positions in the identical underlying commodity or 
commodity derivative.  The delta used shall be that of the exchange concerned, that 
calculated  by the competent  authorities or, where none of those is available  or for 
OTC  options,  that  calculated  by  the  institution  itself,  subject  to  the  competent 
authorities' being satisfied  that the model used by the institution is reasonable. 

However,  the  competent  authorities  may  also  prescribe  that  institutions  calculate 
their deltas using a methodology  specified by the competent authorities. 

The  competent  authorities  shall  require  that  the  other  risks,  apart  from  the  delta 
risk, associated  with  commodity  options  are  safeguarded  against.  The  competent 
authorities  may  allow  the  requirement  for  a  written  exchange-traded  commodity 
option to be equal to the margin required by the exchange if they are fully  satisfied 
that it provides an accurate measure of the risk associated with the option and that 
the method used to  calculate the margin is equivalent to  the method  of  calculation 
set  out  in  the  remainder  of  this  Annex  or  in  Annex  VTII  for  such  options.  In 
addition  they  may  allow  the  requirement  on  a  bought  exchange-traded  or  OTC 
commodity  option to be the same as that for the  commodity  underlying  it,  subject 
to  the  constraint  that the  resulting  requirement  does  not  exceed  the  market  value 
of the option.  The requirement for a written OTC option  shall be  set in relation  to 
the commodity underlying it. 

11.  Warrants  relating  to  commodities  shall be  treated  in the  same way  as  commodity 

options under paragraph 10. 

12. 

The transferor of commodities or guaranteed rights relating to title to  commodities 
in a repurchase agreement and the lender of commodities in a commodities  lending 
agreement  shall  include  such  commodities  in  the  calculation  of  its  capital 
requirement under this Annex. 

20 

fa) Maturity ladder approach 

13. 

The  institution  shall  assign  all  positions  to  the  appropriate  maturity  bands  in 
Table 4,  with  physical  stocks  being  assigned  to  the  first  maturity  band.  For 
markets which have daily delivery dates, any contracts maturing within ten days of 
each other may be offset. 

Maturity band 

(1) 
0  <  1  month 
> 1  <  3 months 
> 3<  6 months 
> 6<  12 months 
> 1<  2 years 
> 2<  3 years 
3 years 
over 

Table 4 

Spread rate 
(in%) 
(2) 
1.50 
1.50 
1.50 
1.50 
1.50 
1.50 
1.50 

14. 

15. 

The institution shall then work out the sum of the long positions  and the  sum of 
the short positions in each maturity band. The amount of the former (latter) which 
are matched by the latter (former) in a given maturity band shall be the matched 
positions  in  that  band,  while  the  residual  long  or  short  position  shall  be  the 
unmatched position for the same band. 

That part of the unmatched long (short) position for a given maturity band that is 
matched by the unmatched  short  (long)  position for  a maturity band  further out 
shall  be  the  matched  position  between  two  maturity  bands.  That  part  of  the 
unmatched long or unmatched short position that cannot be thus matched shall be 
the unmatched position. 

16. 

The institution's capital requirement shall be calculated as the sum of: 

(i) 

(ii) 

the  sum  of  the  matched  long  and  short  positions,  multiplied  by  the 
appropriate  spread rate as indicated  in the  second  column  of  Table 4  for 
each maturity band and by the spot price for the commodity; 

the matched position between two maturity bands for each maturity band 
into which an unmatched position is carried forward,  multiplied by 0.6% 
(carry rate) and by the spot price for the commodity; 

(iii) 

the residual unmatched positions, multiplied by 15% (outright rate) and by 
the spot price for the commodity. 

21 

(b) Simplified  approach 

17. 

The institution's capital requirement  shall be calculated as the sum of: 

(i) 

(ii) 

15% of  the  net  position,  long  or  short,  in each  commodity,  multiplied  by 
the spot price for the commodity; 

3% of the gross position, long plus short, in each commodity,  multiplied by 
the spot price for the commodity. 

ANNEX VIII 

INTERNAL  MODELS 

1. 

2. 

The competent  authorities may,  subject to the conditions laid down in this annex, 
allow  institutions  to  calculate  their  capital  requirements  for  Position  Risk, 
Foreign-Exchange  Risk  and/or  Commodities  Risk  using  their  own  internal 
risk-management  models instead  of  or in combination  with the methods  described 
in Annexes I, III and VII. Explicit  approval of the use of models by the competent 
authority shall be required in each case. 

Approval  shall  only  be  given  if  the  competent  authority  is  satisfied  that  the 
institution's risk-management system is  conceptually  sound  and implemented  with 
integrity and that, in particular, the following  qualitative standards are met: 

(i) 

(ii) 

(iii) 

(iv) 

(v) 

The  internal  risk-measurement  model  is  closely  integrated  into  the  daily 
risk-management process  of  the  institution  and  serves  as  the  basis  for 
reporting risk exposures to senior management of the institution; 

The  institution  has  a  risk  control  unit  that  is  independent  from  business 
trading units  and reports  directly to  senior  management.  The unit  must  be 
responsible 
institution's 
risk-management  system.  It  shall  produce  and analyse  daily  reports  on  the 
output  of the risk-measurement model  and on the  appropriate measures  to 
be taken in terms of trading iimits; 

implementing 

designing 

and 

the 

for 

The  institution's  board  of  directors  and  senior  management  is  actively 
involved  in the risk-control process  and the  daily  reports  produced  by the 
risk-control  unit  are  reviewed  by  a  level  of  management  with  sufficient 
authority  to  enforce  both  reductions  of  positions  taken  by  individual 
traders as well as in the institution's overall risk exposure; 

The  institution  has  sufficient  numbers  of  staff  skilled 
of sophisticated  models 
back-office  areas; 

in  the  use 
trading,  risk-control,  audit  and 

the 

in 

The  institution  has  established  procedures  for  monitoring  and  ensuring 
compliance  with  a  documented  set  of  internal  policies  and  controls 
concerning the overall operation of the risk-measurement system; 

22 

(vi) 

The institution's models have a proven track record of reasonable accuracy 
in measuring risks; 

(vii)  The institution frequently conducts a rigorous programme of stress testing 
and  the  results  of  these  tests  are  reviewed  by  senior  management  and 
reflected in the policies and limits it sets. 

3. 

4. 

The  competent  authorities  shall  also  be  satisfied  that  the  institution's  models 
continue  to  be  reasonably  accurate,  as  evidenced  by  a  regular  back-testing 
programme to be conducted by the institution. 

The institution  must  conduct,  as part  of  its  regular  internal  auditing  process,  an 
independent  review  of  the risk-measurement system.  This  review  must  include 
both the activities of the business trading units and of the independent  risk-control 
unit.  At  least  once  a  year,  the  institution  must  conduct  a  review  of  its  overall 
risk-management  process. The review must consider: 

(i) 

(ii) 

(iii) 

(iv) 

(v) 

(vi) 

the  adequacy  of  the  documentation  of  the risk-management system  and 
process and the organisation of the risk-control unit; 

the integration of market risk measures into daily risk management  and the 
integrity of the management information system; 

the process the institution  employs for  approving risk-pricing models and 
valuation systems that are used by front and back-office  personnel; 

the scope of market risks captured by the risk-measurement  model and the 
validation of any significant changes in the risk-measurement process; 

the  accuracy  and  completeness  of  position  data,  the  accuracy  and 
appropriateness of volatility and correlation assumptions, and the accuracy 
of valuation and risk sensitivity calculations; 

the verification  process the institution employs to evaluate the consistency, 
timeliness,  and  reliability  of  data  sources  used  to  run  internal  models, 
including the independence of such data sources; and 

(vii) 

the verification  process the institution uses to evaluate back-testing that  is 
conducted to assess the model's accuracy. 

5. 

Notwithstanding  paragraph  1,  institutions  using  models  shall  be  subject  to  a 
separate  capital  charge to  cover  the  specific  risk  of traded  debt  instruments  and 
equities  as  described  in  Annex  I  to  the  extent  that  the  competent  authorities 
consider  that  this  risk  is  not  incorporated  sufficiently  into  their  models.  The 
competent authorities  shall in any case set a minimum specific risk charge of 50% 
of the charge as calculated according to Annex I for institutions using models. 

6. 

For the purpose  of paragraph  8(ii) the results of the institution's  own  calculation 
shall be scaled up by a multiplication factor of 3. 

23 

7. 

For the same purpose and in addition to the multiplication factor,  a "plus"-factor 
of  between  0  and  1  shall  be  applied  to  the  results  of  the  institution's  own 
calculation  in  accordance  with  Table  5,  depending  on  the  outcome  of  the 
backtesting procedure outlined below. 

The value-at-risk number calculated by means of the model shall be compared with 
the actual change in value of the portfolio.  Backtesting  shall be carried out daily 
on  the  basis  of  both  effective  and,  assuming  unchanged  end-of-day  positions, 
hypothetical changes in the portfolio value. 

If  the  change  in  portfolio  value  exceeds  the  value-at-risk  calculated  using  the 
model, the target has been overshot.  The number of overshootings,  as set out in 
Table 5, shall be based on a spot check of 250 values. 

Table 5 

Number of overshootings 
fewer than 5 
5 
6 
7 
8 
9 
10 or more 

Plus factor 
0.00 
0.40 
0.50 
0.65 
0.75 
0.85 
1.00 

The competent authorities can, in individual cases, waive the requirement to add a 
plus factor if,  owing to  an exceptional  situation,  an increase in the, multiplication 
factor would be unjustified  and the model is basically  sound. In this context, the 
institution has to prove that an increase would be unjustified. 

In the event of numerous overshootings, the competent authority shall revoke the 
model's recognition  or impose  appropriate measures to  ensure that the  model  is 
improved promptly. 

The institution is to record all overshootings ascertained by back-testing, together 
with the reasons for them, and to notify the competent authorities immediately of 
the extent of the overshootings and the reasons for them. 

8. 

Each institution must meet a capital requirement expressed as the higher of 

(i) 

(ii) 

its  previous  day's  value-at-risk  number  measured  according  to  the 
parameters specified in this Annex; and 

an average  of  the  daily value-at-risk  measures  on  each  of  the  preceding 
sixty  business  days,  multiplied  by the  factors  mentioned  in  paragraph  6, 
adjusted by the factor mentioned in paragraph 7. 

24 

9. 

calculation  of  value-at-risk 

The 
minimum standards: 

shall  be 

subject 

to 

the 

following 

(i) 

at least daily calculation of value-at-risk; 

(ii) 

a 99th percentile,  one-tailed confidence interval; 

(iii)  a ten-day equivalent holding period; 

(iv)  an effective  historical observation period of at least one year; 

(v) 

three-monthly data set updates; 

10. 

11. 

The competent  authorities  shall also require that the model  captures accurately  all 
the material price risks of options or option-like positions. 

The competent  authorities  shall require that the risk-measurement model  captures 
a  sufficient  number  of  risk  factors,  depending  on  the  level  of  activity  of  the 
institution in the respective markets. At a minimum, the following  provisions  shall 
be respected: 

(i) 

interest-rate  risk,  the  risk-measurement  system  shall  model  the 
For 
yield curve  using  one  of  a  number  of  generally  accepted  approaches.  For 
material  exposures  to  interest-rate risk in the  major currencies  and markets, 
the yield  curve  shall be divided into a minimum of  six maturity segments,  to 
capture  the  variations  of  volatility  of  rates  along  the  yield  curve.  The 
risk-measurement system  must  also  capture  the  risk  of  less  than  perfectly 
correlated movements between different yield curves. 

(ii)  For  foreign-exchange  risk,  the  risk-measurement  system  shall  incorporate 
risk  factors  corresponding  to  the  individual  foreign  currencies  in  which 
the institution's  positions  are  denominated.  A  separate  risk  factor  shall  be 
used for gold. 

(iii)  For equity risk, the risk-measurement system  shall use  a separate risk factor 
at  least  for  each  of  the  equity  markets  in  which  the  institution  holds 
significant positions. 

(iv)  For  commodity  risk,  the  risk-measurement  system  shall  use  a  separate 
risk factor  at  least  for  each  commodity  in  which  the  institution  holds 
significant  positions.  The  risk-measurement  system  must  also  capture  the 
risk  of  less  than  perfectly  correlated  movements  between  similar,  but  not 
identical,  commodities and the exposure to changes in forward  prices arising 
take  account  of  market 
from  maturity  mismatches.  It  shall  also 
characteristics,  notably  delivery  dates  and  the  scope  provided  to  traders  to 
close out positions. 

12. 

The  competent  authorities  may  allow  institutions  to  use  empirical  correlations 
within  risk  categories  and  across  risk  categories  if  they  are  satisfied  that 
the institution's  system  for  measuring  correlations  is  sound  and  implemented 
with integrity." 

25 

FINANCIAL STATEMENT 

The proposal has no cost implications for the budget of the European Union 

26 

IMPACT ON COMPETITIVENESS AND EMPLOYMENT 

I. 

What is the main justification for the measure? 

The purpose of the proposed Directive is to refine the EU rules on the capital adequacy of 
investment firms and credit institution with regard to the use of internal risk-management 
models ("internal models") for  the calculation of capital requirements and with regard  to 
capital requirements for commodities and commodity derivatives. 

n. 

Characteristics of the enterprises concerned 

The  proposed  Directive  concerns  investment  firms  and  credit  institutions  in  the 
European Union. 

III.  What are the obligations imposed directly on enterprises? 

investment 

introduces  new  capital  requirements  only  for  commodities  and 
The  proposal 
commodity derivatives  of  credit 
to 
institutions  and 
Council Directive  93/6/EEC.  These  instruments  will  be  subject  to  a  refined  supervisory 
treatment requiring a capital cover better reflecting commodity price risks. As a result, the 
total amount of compulsory capital cover will not necessarily be higher than under current 
legislation, but depends on the portfolio composition of each institution which may change 
frequently.  The  proposed  Directive  furthermore  enables Member  States  to  allow  credit 
institutions  and  investment  firms  to  use  internal  models  for  the  purpose  of  calculating 
capital requirements.  If Member  States  do  so  the  more  accurate risk-measurement may 
result in a reduction of capital charges. 

firms  subject 

IV.  What  obligations  are  likely  to  be  imposed  on  enterprises  through  local 

authorities? 

None 

V. 

None 

Are there any special  measures for SMEs? If so, What type of  measures are 
they? 

VI.  What is the likely effect on: 

(a) 

the competitiveness of enterprises? 

(b) 

employment? 

(a) 

The introduction of the internal models method  will preserve the  competitiveness 
of EU investment firms and  credit institutions which engage in direct  competition 
with credit institutions from non-EU countries already allowing the use of internal 
models  for  calculating  capital  requirements.  The  use  of  internal  models  for  the 
calculation  of  capital  requirements  furthermore  reduces  the  need  to  duplicate 
calculations  for  internal  and  regulatory  purposes,  which  is  expected  to  result  in 

27 

significant  cost  savings  for  investment  firms  and  credit  institutions.  The  use  of 
more accurate calculation methods may also lead to lower capital requirements for 
investment firms and  credit  institutions,  thus releasing  capital which may increase 
the amount of credit available for enterprises. 

For  commodities  and commodity  derivatives the proposed  Directive introduces a 
refined  supervisory  treatment.  The  proposed  measures  are  closely  in  line  with 
regulations  by  another  international  forum  of  banking  supervisors  in  the  wider 
context  of  G-10  countries,  thereby  furthering  the  goal  of  a  level  playing field 
world-wide. 

Furthermore,  an improved  awareness  and  control  of the risks run  by  investment 
firms  and  credit  institutions  contributes  to  the  strength  and,  thus,  to  the 
competitiveness of financial institutions. 

(b) 

In  anticipation  of  the  introduction  of  internal  models  institutions  are  increasing 
their hiring of highly qualified IT personnel. 

VII.  Have the two sides of industry been consulted? What are their views? 

No.  The  proposed  measures  affect  only  the  prudential  legislation  governing  investment 
firms  and credit institutions. 

28 

ISSN 0254-1475 

COM(97) 71 final 

DOCUMENTS 

EN 

09  08 

Catalogue number  : CB-CO-97-156-EN-C 

ISBN 92-78-18693-7 

Office  for Official  Publications of the European Communities 

L-2985 Luxembourg 

29